How Effective is Our Monetary Policy under Taylor?

By Geepu Nah Tiepoh

The Perspective
Jan 17, 2001

More than a decade now, especially since Charles Taylor became president three years ago, Liberia has been without a direct monetary policy. Why is the Liberian economy still denied the most potent macroeconomic policy option available to it? Can there ever be an effective monetary policy under this regime? A country's monetary and fiscal policies are tools used to effect desired economic outcomes, such as employment and economic growth. Monetary policy achieves these aims through changes in the money supply, while fiscal policy does so through the taxing and spending activities of governments. In an open world economy, however, these policies cannot be applied without tradeoffs with other macroeconomic policy goals, such as exchange rate stability and free inward and outward capital flows. In 'Mundell-Fleming' terms, this means that given free capital mobility, governments and central banks can either have monetary policy autonomy under freely floating exchange rates, or give up monetary policy in preference for strong fiscal policy under fixed exchange rates. Under the first option, fiscal policy is less effective, while under the second monetary policy is useless except for influencing international reserves.

With no significant official reserves, the Taylor regime chose a freely floating exchange rate system and monetary policy 'independence', combined with a tight or disabled fiscal policy. Monetary policy under fixed exchange rates requires the holding of sufficient reserves. Although it has yet to establish a formal monetary policy (the Central Bank's draft monetary policy framework was supposed to have been completed only the end of last year), the quasi monetary program being implemented under the IMF Staff-Monitored Program tells the direction of this government's monetary policy. We are told that the overarching monetary policy objective of the Central Bank will remain "price stability" based on a tight monetary and fiscal policy stance. Broad money growth, it has been reported, will remain below the rate of real GDP growth. This implies that the government will continue to refrain from directly effecting the growth of the economy and employment through suppression of fiscal and monetary growth. Instead, it will continue to believe that by maintaining a lid on the money supply through budgetary contraction and tight Central Bank money operations, and by adopting a stable inflation rate, the resulting high rate of interest and stable domestic currency will ultimately attract foreign and domestic private investors to do the job on its behalf.

While such a policy strategy may succeed in raising domestic interest rates and keeping the dollar relatively strong, especially if the rate of money growth is kept below the growth rate of real GDP, and inflation is strictly contained, it is not guaranteed that such high interest rates will encourage productive investment and growth. In fact, interest rates have already been extremely high in the past few years. Average lending rates were 26 percent at the end of March 1998, and they fell only to 17 percent at the end of October 1999. The exchange rate has averaged about L$41-42 in the last eight months ending 2000. But given Liberia's desperate political climate, these high interest rates may attract mostly short-term financial as opposed to long-term productive investments. In fact, high interest rates may not even be sufficient to attract short-term external finance if foreign lenders remain fearful of the country's precarious financial and political systems. Nevertheless, let us suppose for the sake of argument that high interest rates will attract short-term financial investments to the country. Could such finance be borrowed and profitably invested in productive activities in the domestic economy, if lending rates remain so high? High interest rates may benefit foreign and domestic short-term lenders, but they will discourage long-term borrowers and productive investors.

How long can the government keep the economy on tight money and high interest rates without dangerously undermining aggregate demand? There is a strong likelihood that such a policy direction will become unsustainable at some point in time. As national output slowly grows, domestic consumers and foreign importers of Liberian goods and services will need to hold more domestic money to spend, unless the government can resort to deflationary policies. But as long as it implements its "price stability" agenda, any increases in national output will have to be met with increases in real money holdings. Thus, the money supply will have to be increased, unless the government is bent on keeping the economy on a snail pace. If the economy is supplied with more money, and inflation is kept stable as declared, the exchange rate will depreciate as interest rates decline. What will become of the short-term financial investments that had flowed into the economy supposedly because of high interest rates and a strong currency? Insofar as such short-term investments were attracted by these incentives, they will begin to escape from the economy in response. Will the country then have the foreign exchange to support such a capital flight?

It is true that given even a very high interest rate on the Liberian dollar the country may never attract short-term foreign finance in such great volumes as occurred in some Asian countries. But the impact of capital flight will still have serious negative impact on the Liberian economy, especially in light of the fragility of its financial structure. This is why a national monetary policy based on providing interest rate incentives to foreign financial investors as a strategy of promoting economic development cannot be relied upon.